Google Earnings: Profitability Disappoints Even As Revenue Grows

Google ( GOOG ) posted its third quarter results on October 16. The company reported 20% year-on-year growth in revenues to $16.52 billion, which was in line with our expectations. Furthermore, it's operating income from continuing operations declined by approximately 1% to $3.72 billion, primarily due to increased investment in research and development. The markets reacted a bit negatively to the results as the stock was down by over 2% in the aftermarket trading hours. Pricing pressure on online ads continued to drive a 4% year-over-year decline in cost-per-click (CPC). However, aggregate paid clicks, which represent the number of ads served across Google properties, grew by 17% year-over-year. In this note, we will discuss Google's results.

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Cost-Per-Click Falls as Ads on Mobile Increases

We currently estimate that PC search ads and mobile search ads contribute approximately 65% to the firm's value. Online ad spending is expected to increase in general. eMarketer has predicted that worldwide mobile ad spending will exceed $32.71 billion in 2014. Even though mobile search ads are expected to only generate 17% of the company's total revenues in 2014, we expect the proportion to increase to over 35% by 2021.

The cost-per-click, a metric that measures the price paid for the number of times a visitor clicks on a search ad, has been on a steady decline for the past few years. The recent trend is indicative of geographic mix, device mix, property mix, as well as the ongoing product and policy changes. While international revenue contributes nearly 58% of the total revenues, mobile devices account for a huge influx of queries for Google. Advertisers have realigned their ad budgets in favor of mobile devices. Traditionally, CPC for mobile ads is lower compared to that of a PC. As a result, the average blended CPC (CPC for both mobile and PC) declined by 4% year-over-year during the quarter. Furthermore, CPC declined by 1% sequentially as pricing pressure took its toll. However, Google is trying to improve its mobile CPC by directly linking advertisers with mobile applications that are downloadable. Additionally, it continues to develop its estimated total conversion tool, a mechanism designed to understand how mobile ads drive conversions to phone calls from customers, with features like cost device measurement for display ads to improve understanding of how mobile display ads affect advertising campaigns. Going forward, we expect that the growth in mobile advertising will continue to weigh on CPC.

Youtube Boosts Ad Volumes

In our pre-earnings note , we mentioned that we would be closely watching YouTube because it caters to the rapidly growing online video ad space. During the earnings call we got some encouraging metrics from the management, which makes us confident about YouTube as an essential driver of revenue growth going forward. The management stated that it had sold out the majority of its U.S. Google Preferred offering, which represents among the top 5% of popular channels inventory on YouTube. To ensure that YouTube's dominance continues across mobile devices, the company announced new ad formats customized for mobile screens, and expanded YouTube's TrueView ads into AdMob's network of more than 650,000 mobile apps. Considering Google's dominance in the video ads industry, with nearly 159 million unique viewers as of August 2014, we expect it to do well in the mobile video space too. Going forward, YouTube is important for Google because, according to our estimates, this division constitutes just under 10% of its value. Revenues from this division were around $3.7 billion in 2013, and we think that they will continue to grow and reach around $18 billion by the end of our forecast period.

Capitalizing on the Popularity of Android With Play Store

Google's phone division makes up 8% of its value. Google continues to leverage the growing popularity of its Android operating system with app sales on its Play store. Furthermore, Google's apps (such as Google Play, Search and the YouTube app) have over 50% reach for the mobile audience according to comScore. This was reflected in the growth of Google's other revenues, which grew by 50% year-over-year to $1.8 billion, and is primarily composed of revenues from sale of digital content. Going ahead, we expect revenues from digital content to grow to $5.6 billion by 2021, bolstered by the increasing use of Internet to deliver content such as movies, books and music.

Capital Expenditure Continues to Soar

Google continues to invest heavily in Internet infrastructure and reported $2.4 billion in capital expenditures in the third quarter of 2014. Majority of capital investments are for IT infrastructure, including data center construction, servers and networking equipment. Google has been steadily ramping up its spending for the past couple of years, in an effort to improve its return on investment and quality of service.

We are in the process of updating our model. We currently have a $544 price estimate for Google , which is in line with the current market price.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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